Secrets of the IRS Payroll Audit Program

The IRS is in the middle of intensive, line-by-line audits of payroll returns conducted under the auspices of the IRS' National Research Program (NRP). The two-year-old NRP audits program will randomly target 2,000 employers in 2014/

We know more than you think we know. NRP audits focus on worker classification, fringe benefits, officer compensation and Form 1099-MISC. Auditors aren't coming into your business blind. For example, if the source return is Form 1120S, prior and subsequent 1120S forms, W-2 forms, 1099-MISC forms and CP2100 notices will be included in auditors' files. Auditors will also have learned about your business by surfing your website.

Keep cool under pressure. The IRS kicks off each NRP audit with a 3851-B letter. While your Forms 941 and 1120 may be in order, it's not what's on those forms that most interests auditors. The IRS is keen to determine items that could be fringe benefits that aren't on those returns.

With that in mind, here are four tips for handling the NRP process:

1. Assess your liability for hidden fringes by examining every payment rank-and-file employees receive. If the tax code doesn't specifically exclude a payment from income, it's taxable. Hidden fringes can lurk in employer-provided meals, tax-free fringes that exceed their ceiling (e.g., $5,000 a year for dependent care) and reimbursed expenses that aren't paid under an accountable plan.

2. Go through the same process for executive compensation, but also include executive compensation agreements, loan agreements, and non-qualified deferred compensation plans. Additional hidden fringe benefits may lurk in executive dining rooms, country club dues, sky boxes, and chauffeur services.

3. To determine the status of independent contractors, apply the safe harbor factors of Section 530 of the Revenue Act of 1978: You treat all independent contractors consistently by filing Forms 1099-MISC, if necessary; you treat all similar independent contractors similarly; and you have a reasonable basis for your actions.

4. Forms 1099-MISC must be provided to non-corporate service providers to whom you pay $600 or more a year. Service providers' Taxpayer Identification Numbers (TINs) must be reported on the form. Auditors will look through your accounts payable books to assess compliance. Warning: If you don't have service providers' TINs prior to payment, you must backup withhold at the 28% rate.